Term: ACCOUNTING CONSERVATISM

Accountants are notoriously conservative people. Conservatism applies to incomes, expenses, liabilities and assets of unknown amounts. To be conservative means generally expecting incomes to come in later and be smaller and to expect expenses to come in earlier and be larger. The problem is that Generally Accepting Accounting Practice (GAAP) does not precisely determine exactly how conservative an accountant must be in many situations. This leads to difficulty in comparing the financials of different companies – some are more conservative than others. For example, a construction company has a contract to build a road. This will take several years to complete and the problem arises over when exactly the income and hence the profits are recognised in the books of account. Should they be recognised when the contract is won, but before any work is done – or when the contract is completed and full payment received – or on some partial basis. The exact method chosen could significantly impact on the company’s profitability in the various financial periods covered. Obviously, the most conservative approach would be only recognise the income once the work is completed and the final payment is received – but is that the best method? It will reduce profits in the years prior to completion and then boost profits in the year of completion. There are no hard and fast rules.

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